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  • Writer's pictureThomas Hayes

Factor Based Investing

Updated: Jun 15, 2023

Factor Based Investing: What is it?

Factor-based investing is an investment strategy that seeks to pursue superior returns by focusing on specific factors, or characteristics, that historically drive equity returns. It focuses on the characteristic’s certain securities exhibit, such as Value, Momentum, Size, Quality, and Low Volatility, and segments the market into these different pieces, allowing asset allocators to determine more clearly what drives returns. For the purposes of this explanation, the two factors we’ll focus on are value and momentum.

Momentum refers to the tendency of stocks that have performed well recently to continue to perform well in the near future, and stocks that have performed poorly to continue to perform poorly in the near future. Implementing a momentum-based strategy involves buying stocks that have recently experienced strong positive price movements. This approach aims to capitalize on market trends, which has historically been shown to produce superior returns.[1]

Value, on the other hand, refers to purchasing assets that are undervalued by the market, and likely to outperform in the long run. Value-based strategies typically involve buying assets that are trading at a discount to their intrinsic value, which can lead to superior returns as the market eventually recognizes their true worth.[2]

How Can It Be Applied to My Portfolio?

Traditional portfolio construction is often looked at from the perspective of a ratio of stocks and bonds. For example, a traditional conservative portfolio might be made up of 60% stocks and 40% bonds, whereas a more aggressive portfolio might be made up of 90% stocks and 10% bonds. However, viewing these asset classes as homogenous, with stocks as a driver of long-term returns, and bonds as a source of relative stability, income, and diversification, doesn’t fully reflect their role in a portfolio. What about the stocks held within that 60% or 90% of the portfolio? By diving down below the surface of those broader asset classes, and pairing together factors with low correlation, investors can improve diversification within the stock portion of their allocation.[3]

Value and momentum tend to exhibit low correlation, leading them to perform differently under different market conditions. Therefore, by combining value and momentum factors, investors can potentially pursue superior returns, while also diversifying within the portion of their portfolio held in stocks. Overall, this combination can create a portfolio that may be better positioned to weather changing market conditions, and help investors maintain a balanced, and diversified investment portfolio that is well-positioned to deliver strong returns over the long term.

Why It Matters Now

As of March 23rd, 2023, the top five companies in the S&P 500 made up more than 21.45% of its weighting. [4] Meaning that any investor who is only purchasing an S&P 500 index fund is heavily weighted to these five companies within their equity allocation. Incorporating a factor-based component into the portfolio can help to reduce an investor’s relative weighting to the top of the S&P 500, and improve diversification within the equity allocation. The use of systematic quantitative models to implement factor-based strategies can also help reduce emotional biases and improve portfolio decision-making. It also offer investors a range of other benefits, including potential long-term returns, improved diversification, and cost-effectiveness. Of course, this can also increase the probability that the portfolio deviates from the return of the broader market. However, over the long term, incorporating factors with low correlation, such as value and momentum, on an equal-weight basis, can potentially improve risk adjusted returns for investors.

The opinions voiced in this article are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which strategies or investments may be suitable for you, consult the appropriate qualified professional prior to making a decision.

All investing involves risk including loss of principal. No strategy assures success or protects against loss. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.

Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price.

Value investments can perform differently from the market as a whole. They can remain undervalued by the market for long periods of time.


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